Here at The Motley Fool, we tend to scorn financial products that enrich the people who sell them, but offer investors subpar returns.
So it should come as no surprise that we really don't like most annuities.
By and large, annuities are the kind of product Fred Schwed was thinking of when he wrote his classic book, Where Are the Customers' Yachts?:
An out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, "Look at those bankers' and brokers' yachts." The naive customer asked, "Where are the customers' yachts?"
The high (often crazy-high) fees and low returns on most annuities mean that the folks selling them, not the customers they supposedly serve, end up buying the yachts.
You'd think that investors would avoid these products. Yet no less an eminence than retirement whiz John Greaney, a regular Fool contributor and former engineer who successfully retired at age 38, has said repeatedly that under some circumstances, one type of annuity can be a useful component of your overall retirement strategy.
Writing in the March 2005 issue of the Fool's Rule Your Retirement newsletter, Greaney showed how adding a lifetime income annuity to your retirement portfolio can help ensure that you don't outlive your retirement savings.
While you should check out his article for the full analysis (if you're not a Rule Your Retirement subscriber, just grab a no-obligation free trial for 30 days of access), the essence of it is quite simple.
But first, a bit of background about annuities.
One of Wall Street's favorite products
An annuity is a contract between you and (usually) an insurance company. In exchange for a big chunk of cash today, the insurance company agrees to pay you an income for a specified period, which can be a specific number of years, or the rest of your life.
There are many types of annuities, but for our purposes, we will describe three broad categories: The (sometimes) good, the bad, and the ugly. In reverse order:
The ugly: Equity indexed annuities. These products are one of the most notorious salesman-enrichers out there. They can even end up doing more harm than good. Sold on the promise of a "guaranteed" rate of return based on the performance of an index, the equity-indexed annuity's fine print inevitably ensures that your return will be several percentage points lower than the index's.
Worse, the return is often capped. When the S&P 500 has a big year like 2009, in which it gained 26%, you might be looking at no more than a 10% return. And that's before fees, which are somewhere between outrageous and insane. Don't even start me on the tax disadvantages.
Let's just say that a well-built portfolio of stocks should trounce this boondoggle of a product's performance easily. Such a stockpile would include:
- Dividend-rich blue chips, like Procter & Gamble
(NYSE: PG)and AT&T (NYSE: T).
- Global powerhouses like GlaxoSmithKline
(NYSE: GSK)and energy giant Total SA (NYSE: TOT)
- Small up-and-comers like CAPS favorites Titanium Metals
(NYSE: TIE), Foster Wheeler (Nasdaq: FWLT), and optionsXpress (Nasdaq: OXPS).
The bad: Variable annuities. I ranted, er, wrote about these high-fee products (nearly 2.5% a year on average, compared to about 0.2% for an index fund) and their disadvantages at length a few years ago. The fees are high, the returns are iffy, the "surrender charges" imposed if you need your money back are brutal. There some tax advantages, but they usually don’t come close to compensating for the downsides.
The sometimes-good: Lifetime income annuities. These are basic, classic annuities -- you hand over a lump sum, you get a specified income for the rest of your life. While they won't give you the returns of a well-structured portfolio of stocks and bonds, as Greaney points out, the best of them can provide you with cost-effective insurance against outliving your money. They're worth serious consideration if you're near retirement and your nest egg isn't as big as you'd like.
Even if you think your nest egg is big enough, and you're concerned about managing an investment portfolio while you're retired -- and don't want to be dependent on an advisor -- a lifetime income annuity can make some sense.
There are trade-offs. You'll probably have less money monthly than you would with a regular investment portfolio, and you could be giving up a large estate -- but for some, those are worth the peace of mind.
If you're considering this option, look for low-fee offerings backed by highly rated insurers.
And do look at Greaney's article for a fuller exploration of the pros and cons of annuities -- and if you're new to Rule Your Retirement, check out the excellent materials on asset allocation while you enjoy your free trial. You might decide that sticking with an investment portfolio is easier than you thought.